Financial investors have been at the forefront of the development of the PFI/PPP market. It was their willingness to raise the funding, invest time and effort in bidding the first PFI projects in conjunction with contractors and operators which led to the creation of the market itself.

In the early days of the market, the only route available for financial investors to participate was to commit substantial time, effort and resources in supporting bids and accepting the consequent risks, costs and time inherent in any tender for a major PFI contract.

However, of the 530 PFI projects signed to date, it is estimated that 65% have reached construction completion and moved in the operational phase, with many more projects being forecast to reach this point over the next two years.

Whilst the high bidding costs and long lead times of PFI/PPP contracts are a cause of concern, apart from very few limited cases, PFI/PPP contracts have been a great success for those companies in the market. The recent plunge in share prices of certain major players in the PFI market cannot hide the fact that they nonetheless have secured annuity income of up to 25 years from a prime covenant on projects which for the most part are shown to be operationally successful and profitable. However, this plunge in share prices has led to certain contractors and operators reassessing their capital requirements and realising the need to recycle capital from certain of their projects to fund further growth.

This, combined with the maturing of the market and the availability of a wide variety of operational PFI/PPP schemes with verifiable trading and cash flow, has opened up further opportunities in the secondary market, which is viewed as a natural progression of the PFI/PPP market.

What is the PFI secondary market?

As the UK PFI market matures and more projects reach their operational phase, a secondary market for private finance equity is gaining momentum.

In the construction and commissioning stages of a PFI project there is a high degree of risk in that the SPV has to build the asset and ensure it works. Whereas on construction completion, the risk profile of a project reduces thereby increasing the value of the original equity investment, making divestment an attractive option for both financial investors and commercial players actively managing their investments, and therefore allowing such persons to realise potential gains from taking that risk.

Why a PFI secondary market?

There are various drivers for the emergence of the PFI secondary market:

? Some financial investors have no interest in taking on a traditional PFI project to design, build and operate a public service. The high bid costs and upfront costs have deterred such investors from participating other than through the secondary market.

? Certain commercial players will expect to divest themselves of their equity investment after around five years. This is seen as a way for such investors to recycle capital; churning PFI investments enables these investors to increase their working capital ability and to provide capital to invest in new schemes. The secondary market is able to free up the primary sponsor for further investment; without the development of the secondary market, the primary market would become constrained.

? Gains realised by construction firms, service providers or financial investors selling their stake in a project can be used to offset losses from unsuccessfully bidding for other PFI projects.

Another driver is where a financial investor or commercial player has a U-turn in strategy. In particular, this may arise if a financial investor or commercial player has financial difficulties. For example, if such investors have run out of balance sheet capacity to absorb the various projects and may be unable to spread bid costs when preparing annual accounts, or need to reduce their debt, or their exposure to PFI generally. As a result of such occurrences there is now an element of distressed selling.

Opportunities

Investment in the secondary market is estimated to be worth £2 billion, with secondary market funds already being established (including SMIFF (the Secondary Market and Infrastructure and Facilities Fund of Abbey National and Babcock & Brown), and funds by Innisfree and M&G, Barclays Capital, and HSBC) to invest directly in existing projects. Despite the suggestion of PFI being dead, the creation of these funds heralds the next step in PFI.

While precise investment parameters will be specific to individual funds, the secondary funds are expected to take relatively long-term positions in investments which offer post-construction risk yields and which do not necessarily have substantial embedded refinancing upside.

The secondary funds will provide the PFI market with liquidity, enabling companies to restructure their investments or to sell their stake in its entirety, thereby freeing up cash for reinvestment in other projects.

Refinancings or variations

The timing for sales and purchases in the secondary market may be influenced by the following circumstances: refinancings or variations.

Refinancings of PFI projects are most likely to occur following construction completion (when risks have reduced) and some time into the services period when a stable performance track record has been established. Sponsors are likely to view refinancing as not only an opportunity to extract their return earlier than would otherwise be the case but also an appropriate moment to either reduce their equity and/or sub-debt interest in the project or exit the project altogether.

While OGC Guidance has enshrined a 50:50 share of ?refinancing gain?, we understand that there are in the region of 400 closed PFI projects which have bespoke (or no) refinancing provisions which are or will soon be in a position to refinance. The OGC ?Code of Conduct? in October 2002 on the refinancing of earlier PFI projects suggests a 30:70 split in any event, but the ability to carry out a range of refinancing options will depend on a review of the relevant provisions of the project agreement from the sponsors' and lenders' perspectives.

Furthermore, we are starting to see the public sector requesting more and more large variations in the services period, particularly in the accommodation sector. Unless these variations are going to be wholly public funded, there is going to be a requirement for the injection of a substantial tranche of further senior or mezzanine debt and equity/sub-debt. The implications of large variations on projects and their financing are only recently becoming clearer (and continue to be developed) but it may be the case that existing lenders may have concerns about the additional funding requirement and a change to the project's risk profile. Furthermore, sponsors (or at least some of them) may not have the desire or capacity to inject further equity/subordinated debt. The opportunity for sale and purchase in the secondary market is therefore available. The possible downside is that a purchase will be being made at a time when construction risk is being injected back into the project although against the background of a successful construction completion having been achieved and (hopefully) a stable performance of existing services. Furthermore, a large variation may provide the impetus (or requirement depending on the existing lenders' views) for a refinancing of the project.

Issues

For those who wish to participate in the PFI secondary market there are various issues to consider:

? Tax ? there are a number of important tax issues on the structure and financing of the acquisition vehicle (certain advantageous arrangements may be appropriate, for example, for US acquirers). Additional tax considerations apply to the sale and purchase of the interests in the SPV, together with interests in any other SPVs which have the same shareholders. In particular, purchasers and sellers should seek to ensure the continuing availability of tax losses, maximise CGT exemptions and minimise stamp duty costs.

? Due diligence ? purchasers should consider when undertaking due diligence on existing PFI documentation that extensive due diligence will have already been undertaken by the shareholders of the SPV and, more importantly, the SPV's senior lenders to obtain credit approval. Existing risk matrices should also enable purchasers to take a commercial approach to due diligence. As stated above, it is likely that most sale and purchases in the secondary market will occur following construction completion when construction risks will have reduced.

  Purchasers acquiring an equity interest in an SPV in the secondary market need to consider the motives of the seller, whether it is a commercial shareholder or a financial investor. In particular, purchasers should look at ongoing sub-contracts with a fresh critical eye if the seller has an ongoing sub-contract. Similarly, shareholder documentation should be carefully reviewed as the rights of a selling minority shareholder who is a sub-contractor may not be appropriate for a purchaser.

? Documentation ? although a purchaser in the secondary market will be buying into an existing PFI, documentation required will include:

? sale and purchase agreement

? tax deed (if acquiring equity)

? disclosure letter

? new subordinated loan instrument (possibly).

If an equity interest is being acquired, shareholder documentation will need to be amended, bearing in mind those issues which arise out of due diligence.

? Change of control ? due diligence will reveal those consents that a seller will need to obtain prior to selling its equity stake. In particular:

? The lenders' consent under the finance documentation

? The public sector's consent under the project agreement

? The shareholders' consent under the shareholder documentation.

? Finance ? due diligence on the finance documentation will be necessary. Consideration should, in particular, be given to the provisions on early repayment, the consequences of late payment and refinancing.

Where a purchaser is entering into a new subordinated debt instrument, purchasers should be aware that senior lenders may wish to extend any existing intercreditor/ subordination arrangements.

Conclusion

An extension of the PFI secondary market may be the securitisation by operating shareholders of their equity cashflow (either in respect of individual projects or grouped transactions). In addition, it has been suggested that purchasers in the PFI secondary market may seek to create specific sector units, and such a move has the potential to encourage more equity investment if SPVs can become real long-term companies. If this can be achieved, we may see a move away from private equity investment of PFI projects and a move towards corporate finance investment with the possibility of such sector specific units becoming listed in the future.

There is therefore good reason to suggest that there will be considerable movement within the equity ownership of PFI projects in the near future and, in particular, many see the sale of equity investments as a natural progression of PFI.